Question
Assume that you are the CFO of Microsoft Company and you were asked to estimate the cost of capital. Microsoft has 1500 bonds that now
Assume that you are the CFO of Microsoft Company and you were asked to estimate the cost of capital. Microsoft has 1500 bonds that now has 20 years to maturity and a 7.00% annual coupon. The bond currently sells for $925 and the companys tax rate is 30%. Moreover, Microsoft has 60,000 common stock ($10 par value) and the risk premium over its own debt cost is 5.00% and the the yield on a Treasury bond is 4%.
The company recently decided that its target capital structure should have 35% debt, with the balance being common equity.
Furthermore, the CEO identified two investments opportunities. Project A will cost $50,000 and Project B will cost $90,000. The CEO has decided that it will invest in one project but not both. The expected cash flow that will be generated by both project are listed below:
Project A Project B
Initial capital expenditure $50,000 $90,000
Cash year 1 25,000 30,000
2 20,000 40,000
3 15,000 14,000
4 10,000 26,000
5 10,000 10,000
In addition, the following table provides the close share price for Microsoft Corporation (MSFT) and NASDAQ, and the net income for MSFT:
| MSFT | NASDAQ | Net Income | Total Dividend | |
| 2015 | $50 | $5,000 | $200,000.00 | $130,000.00 |
| 2016 | $55 | $5,500 | $206,000.00 | $133,900.00 |
| 2017 | $50 | $6,000 | $214,240.00 | $139,256.00 |
| 2018 | $60 | $6,750 | $224,952.00 | $146,218.80 |
| 2019 | $66 | $7,500 | $237,324.36 | $154,260.83 |
| 2020 | $72 | $7,853 | $253,937.07 | $165,059.09 |
Required:
- Calculate the value of total risk and market risk for Microsoft.
- Calculate the best estimate of the cost of debt and the cost of equity?
- In your opinion, what is the best estimate of the firm's WACC, justify your answer?
- Calculate each of the following for both investments opportunities (Project A and B):
- The Payback Period (PP)
- The Accounting Rate of Return (ARR)
- The discounted Payback Period (DPP)
- The Net Present Value (NPV)
- The Profitability Index (PI)
- The Internal Rate of Return (IRR)
- The Modified Internal Rate of Return (MIRR)
- Advice the CEO, with reasons, which project should be selected.
- Choose TWO of the above methods of investment appraisal and discuss its advantages and disadvantages.
- If you have one million dollar, would you invest in MSFT, NASDAQ, or both, justify your answer?
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